Financial Risk Management - Term Paper Example

Financial Risk Management The 2008 financial crisis influenced the performance of financialinstitutions. The federal government bailed out the institutions that were considered “Too Big to Fail” in order to prevent the collapse of the world economy. The financial crisis had resulted to closure of some institutions while others merged to strengthen their operations. Although the government considered it essential to provide financial support to the institutions in order to save them from collapsing, some economists felt that such a move was unfair, and institutions should have been left to struggle on their own. There was no guarantee that those financial institutions could actually collapse if the government did not give them financial support. Furthermore, government intervention limits the potential of the institution’s leaders to explore means to save their organization hence leaving the directors of the institutions without experience to handle future financial crisis. The Islamic financial institutions differ from conventional financial institutions because they pursue the interest of investors as opposed to conventional institutions which are capitalistic. The study focuses on how conventional and Islamic institutions are operated and the main differences and similarities between the two financial institutions. Introduction In a capitalist nation like Unite States individuals pursue personal goals as opposed to broader economic goals (HBO, 2011). The role of the state in such a situation is to make policies that will protect citizens and their property, creating an enabling environment for investors to pursue their interests. The state collects tax revenues from individuals and corporations in order to provide capitalist with level playground on which they can be able to conduct their activities (Stockman, 2013. P. 342). However, the government has the responsibility to safeguard the economy because the economic status of a nation collectively affects lives of the citizens. Capitalists’ plays significant roles in the economy hence their activities are intertwined hence making it too hard for the government to ignore their activities (DarkAngelStarQ, 2009). Since economic growth is affected by the roles of capitalists the government cannot ignore the performance of private businesses completely because poor performance of the private businesses will affect the implementation of government policies (Ferguson, 2008). The study explores the risks facing financial institutions in the documentary “Too Big to Fail” and also the risks facing Islamic financial Institutions. Summary of Literature Review According to DarkAngelStarQ (2009), “Too Big to Fail” documentary focuses on the period of global economic meltdown in 2008 and provides the causes of depression and strategies applied by Lehman Brothers to mitigate the crisis. Before the crisis, Lehman Brothers had become critically exposed to subprime home loans which mortgagees could not pay. Due to serious credit shortages that faced Lehman brothers, its Chief Executive officer Dick Fuld started lobbying for an opportunity to make an external investment without success (Wallace, 2013). The CEO contacted the U.S. Treasury Secretary Henry Paulson to request financial support, but this was not possible hence Lehman was declared insolvent. The insolvency of Lehman Brothers had detrimental effects on global economy and this resulted to rapid decline in the value of market stocks (Dobelli, 2013. P.143). The government intervened by releasing funds to support financial institutions in order to revive the economy and get the credit flowing (HBO, 2011). Some institutions such as Fannie Mae and Freddie Mac were taken under the control of Federal government. The government and the economists thought that the big financial institutions were “Too Big to Fail” hence they needed assistance to save them from failing. The then U.S, "Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke" requested for seven hundred million U.S. dollar to bailout the banks and other financial institutions (Banerjee & Esther, 2011, p.74). The heads of financial institutions were in panic and they struggled to get assistance from whatever means they could to save their institutions. Some directors engaged non-official meetings with eminent personalities just to save the institutions (Dobelli, 2013. P.164). However, some of the directors pursued individual interests. Similarities between Islamic and Conventional Financial Institutions Both conventional and Islamic banks share similar risks as a result of similar conditions in which they operate (Ferguson, 2008). For example, both banks face operational risks which refer to loss as a result of failure of the internal procedures and external factors (appendix 2). Another common risk is liquidity risk which is the loss a bank faces due to its inability to clear its liabilities. Market risk is a risk that faces banks as a result of changes in market values of the trading stocks or exchange rate of the currency (Wallace, 2013). Finally, credit risks occur when a bank is not able to meet its credit obligations in accordance to the terms of the agreement. Displaced commercial risk occurs when the Islamic bank is compelled to pay investors returns with the entire profit attained in order to retain the investors (Shodiq, 2012) (appendix 3). Equity investment risk faces the Islamic banks as a risk due to a contract deal in which both parties to the contract must share the proceeds of the deal. Both conventional and Islamic financial institutions venture into various financial activities ranging from investment banks, commercial banks, investment companies to insurance companies (Shodiq, 2012) in order to create income from the assets. The reason for investing in different assets is to spread market risks and maximize returns. Differences between Islamic and Conventional Financial Institutions Islamic institutions operate under Shariah laws that require them to venture in activities that are lawful and not to exploit the investors (Shodiq, 2012). The aim of Islamic financial institutions is to manage resources for the investors and share returns with the investors (Appendix 1). On the other hand conventional financial institutions must comply with state laws but they are not answerable to any religious laws. The conventional banks accept deposits from the depositors and issue the same money as loans to interested borrowers. Also, they issue returns to the depositors which add operational costs to conventional banks. They banks also pay a fixed upfront to the depositors for the period agreed by the parties (DarkAngelStarQ. 2009). The returns of the investments belong to the bank apart from dividends paid to shareholders of conventional financial institutions. In case of default of payment by the borrowers the banks may have to look for another source of funds to compensate the depositors (Appendix 5). However, Islamic banks take investment from the investors and make investments on behalf of the investors without any interest charges. The income earned from Islamic financial institutions is shared with the investors. Conventional financial institutions On the other hand, Islamic financial institutions spread their investments over different halal portfolio so that if some assets fail to yield returns or if they yield negative returns the positive yields from the other assets will upset that loss as a risk mitigation strategy. Conventional financial institutions invest in ventures that have probability of returns make speculative investments even though such ventures bear immense risk in order to control the risks with hope of maximizing returns. On the other hand, Islamic banks take funds from investors and invest in Halal assets on behalf of the investors in order to generate income (Stiglitz, 2012). There is no specified return for investors and the upfront for investors in uncertain because this will be paid according to the amount gained from the investments (Appendix 6). In case the investments fail to yield returns investors will not get any returns from their investment (HBO, 2011). Finally the investments are interest free hence the bank is not obliged to pay interest to investors in Islamic financial institutions (Appendix 8) while the conventional financial institutions have to pay depositors some interest and an upfront after particular time (Shodiq, 2012) Synergies In “Too Big to Fail” documentary, the banks faced default risks because borrowers were unable to repay huge money advanced to them (HBO, 2011). The consequences were loss of credit by the subsidiary banks which threatened to bring down the entire financial institutions globally. Lehman attempted to seek for a government bailout in order to solve the crisis (appendix 4). This was a different scenario from that observed in Islamic banking industry because the management of Islamic financial institutions uses internal control systems to manage the risks (Shodiq, 2012). The Islamic finance laws require borrowers to declare the asset against which the bank will advance loan. Risk management concepts require lenders to evaluate the credit ratings of the borrower (DarkAngelStarQ. 2009). These approaches serve as a guarantee to the lender that the person taking the loan has potential to repay back without failure. The ability of the bank to achieve its goals depends on the probability of the occurrence of risk and impact the occurrence of risk will have on the bank. If both risks and probability of loss are high then the bank is very unlikely to achieve its objectives (Dobelli, 2013). If both the probability of risk and the impact of loss are low the banks will have higher chances of achieving their goals (Appendix 7). Conventional banks minimize risks by lending funds to the borrowers who have good collateral for security against the loans advanced to them. However, Islamic banking industry ensures that the money they collect from the investors is adequately invested in halal assets and also they ensure the investment activities are morally acceptable (Stiglitz, 2012). It is against Shariah law for the Islamic financial institutions to invest resources in Haram projects or charge interests on the investors (Shodiq, 2012). This minimizes the risk of rejection by the community and other losses as a result of legal suits against the banks. Also, the banks ensure the investments are made in assets with higher chances of earning returns in order to be assured that the resources are not wasted (Dobelli, 2013). Conclusion In conclusion, the 2008 financial crisis affected the lives of the people adversely because the state had to spend tax payer’s funds to revive the “big” institutions. This was serious impunity by senior leaders of financial institutions because the money belonging to the public was used to settle private debts. Capitalists should responsible for their own conduct and there should be a distinct line between private and communal affairs. Government intervention limits the potential of organization’s director’s to establish cause and find a solution to the problem. Therefore, even in the future those directors may lack strategies to establish the cause and resolve an issue relating to the financial meltdown. The Islamic financial institutions are accountable to the public and directed by Shariah laws on they conduct businesses hence they do not seek external intervention in case of financial crisis. The returns from Islamic financial institutions are shared with investors since they are co-investors. List of References Banerjee, A. V. & Esther, D. 2011. The Poor Economics: Radical Rethinking of the Way to Fight Global Poverty. PublicAffairs, Pp. 43-117 DarkAngelStarQ. 2009. Fall of Lehman Brothers. Retrieved on 18th February 2014 from; Http://www.youtube.com/watch?v=Ms_tnEe4wFk Dobelli, R. 2013. The Art of Thinking Clearly: Better Thinking, Better Decisions. Hodder & Stoughton. Pp. 123-184 Ferguson, N. 2008. The Ascent of Money: The Financial History of the World. Penguin Press pp. 135-211 HBO, 2011. Too Big To Fail: Opening The Vault On The Financial Crisis (HBO Films). Retrieved on 18th February 2014 from; Http://www.youtube.com/watch?v=wVV6dzDOgQ0 Kindleberger, C. P. & Robert, Z. A. 2011. The Manias, Panics and Crashes: History of Financial Crises, 6th ed. Palgrave Macmillan, Pp.1-97 Shodiq, M. 2012. Risk Management in Islamic financial Institutions. Retrieved on 22nd Feb. 2014 from Http://islamicfinance-global.blogspot.com/2012/11/risk-management-in-islamic-financial.html Stockman, D. A. 2013. The Great Deformation: Corruption of Capitalism in America. Perseus Books Group. Pp. 325-412 Stiglitz, J. E. 2012. The Price of Inequality: How Todays Divided Society Endangers Our Future. W. W. Norton. Pp. 207-276 Wallace, D. F. 2013. Fate, Time, and Language: An Essay on Free Will. Columbia University Press. Pp. 21-89 List of Appendices Appendix 1: Different types of risks facing banking and financial industry GENERIC RISKS RISKS SPECIFIC TO ISLAMIC BANKING Credit risks Equity risks Market risks Transparency risks Operational risks Rate of return risks Liquidity risks Shariah compliance risks Displaced commercial risks Source; Shodiq, 2012 The table above shows the types of risks facing financial institutions. For example, generic risks are faced by all financial institutions, but for the Islamic financial institutions they face additional risks above generic risks. Appendix 2: Risks affecting earnings of Islamic financial institutions Source; HBO, 2011 The figure shows risks that are likely to affect the earnings of the Islamic financial institutions. The banks must employ strategies to minimize these risks in order to increase the earning. Appendix 3: The relationship between Islamic banks and investors Islamic bank Investors Islamic bank Investing Source; Shodiq, 2012 The Islamic banks and their clients are related as investors. The banks collect funds from the savers and invest on the behalf of those savers. The strategy is to gather resources for a common investment opportunity. The banks and depositors are co-investors hence their share returns or losses. Appendix 4: The economic relationship of financial institutions Source; Shodiq, 2012 Individual financial institutions results to merger during harsh economic times and can get assistance from the government for bailout in case they cannot contain the situation. Appendix 5 Relationship between conventional banks and the clients Source; This shows that in conventional banks the clients are either depositors or borrowers. Therefore, the role of the bank is to collect deposits from savers and lend the same to borrowers at some interests. The interest rates paid on the amount borrowed makes the banks revenue. Appendix 6: Banks and financial institution mergersSource; HBO. 2011 During harsh economic times like that of 2008, small financial institutions combine to form bigger and stronger financial institutions that can easily overcome the market challenges. For example, in 2008 financial crisis several firms in the financial industry formed fewer but stronger institutions such as Lehman Brothers. Appendix 7: Relationship between probability of risks and their effects on banks Probability Inability of bank to of Loss meet its goals Effects to bank If the probability of occurrence of risk and the impact of the risk on the bank are high the bank is much unlikely to meet its goals, and stringent strategies are essential to mitigate the risk. Appendix 8: Nature of Islamic banks investments assets Source; Shodiq, 2012 This figure shows the nature of assets that an Islamic financial institution can venture into. Read More